Sometime in the past I wrote about the true cost of management fees, but that blog post may have been deleted in the process of culling older posts. Regardless, it is time to go through the mathematics of management fees. Let’s walk through an example.
Here are the critical assumptions to consider. I will neglect to take into account the fund or ETF expense ratios, but we want to keep them as low as possible. VTI is frequently used in ITA portfolios and the current cost is 3 basis points or 0.03%. That is very low.
- Assume the rate of inflation is 3.2% or about the average over the past 70 to 80 years.
- Further, assume the professional manager is charging 1.0% of assets. One might find an competent advisor who will charge 40 to 50 basis points. Most Robo Advisor portfolios run around 25 basis points. Schwab is free, but Schwab holds about 7% to 8% in cash. This is a drag in a bull market.
- Assume your portfolio returns 8.0% annually or very close to the annualized return of the S&P 500. If you think it should be 9% or 10%, just substitute the “correct” percentage into the equations below.
And now for the mathematics to determine the true cost.
We first need to calculate the true rate of growth and that is the portfolio return (8.0%) minus inflation (3.2%) or 8.0% – 3.2% = 4.8%.
Since the value of the portfolio is already yours, the fees are subtracting money from dollars that is already yours.
Cost of fees is not 1.0% of assets, but rather 1.0%/4.8% = 20.8. Wow! That is a high cost to pay a manager.
Look at it this way. Assume you have a portfolio worth $100,000 at the beginning of the year and it earns 8.0% by the end of the year so the new value is 1.08 x $100,000 = $108,000. However, inflation “ate” away 3.2% so the real value at the end of the year is 1.048 x $100,000 = $104,800.
The active manager is going to charge one percent (1.0) of $108,000 or 0.01 x $108,000 = $1,080. When taking inflation into account your are left with $104,800 – $1080 = $103,720. Instead of a gain of 8.0% the gain is actually 3.72%.
As investors we cannot control inflation, but we can control our management fees.
If I’ve made any false assumptions or made any mathematical errors of logic, please point them out and I will correct them. If you have a different way of calculating the cost of management fees, post it in the Comments section.
We know how difficult it is to “beat the market” where the equities market is generally considered to be the S&P 500 (SPY) or the total U.S. Equities market (VTI). I’ve hinted at this possibility before, but does it not make sense to populate a portfolio using only SPY or VTI? This is close to what we do in the Dual Momentum™ portfolios and more recently, the Copernicus portfolio.